The Tooth Fairy

A study by FreddieMac, one of the quasi-governmental agencies that buy residential mortgages, shows that about one in five sub-prime borrowers would actually have qualified for a loan at A-paper rates had his lender tried to get one. This is pretty scary.

I think that way to many borrowers do not have an adequate sense of caution when dealing with the mortgage industry, hence the title of this article. Believing in the Tooth Fairy is OK, just don't think that she works in my industry. The other way of saying this is caveat emptor, buyer beware.

Of particular interest is Ameriquest Mortgage Co., the largest lender to sub-prime borrowers, those with impaired credit. This company's lending practices are currently the subject of investigations by Attorney's General in 30 different states. The company is privately held but has stated publicly that it has set aside some $325 million in reserves to pay potential liability that may result from adverse findings.

If you have been paying attention, you will also have noted that this company was a major sponsor of the half-time show at the last Super Bowl, is a sponsor of the Rolling Stones current concert tour, and even bought expensive time during the just concluded World Series.

Now if it occurs to you that this is expensive advertising, I concur. In fact I find hard to think of advertising that would be more expensive! How can you afford to pay for that advertising unless you are making a bundle on the borrowers it attracts? You can't, so it is obvious that the loans that Ameriquest funds are very profitable to them.

This poses another question. I've been in the mortgage business for over 25 years and my strongly held belief is that it is a low margin business where lenders have to be efficient and well-managed to survive. Another proof of that is that the casualty rate in the mortgage business is quite high. Forgetting the slaughter among the S&L's in the 1980's, the years since then have been unkind to the mortgage industry with lots of companies closing their doors.

So how can Ameriquest afford all this advertising? By making a lot of profit on each loan. The fact is that sub-prime lending is a lot more profitable than A-paper lending. An A-paper borrower may pay, say 6% and 1 point for a loan whereas the same loan from a sub-prime lender might be 7.75% and 3 points. On a $200,000 loan the difference in points alone is $4,000.

Virtually all companies sell loans they produce to firms in the so-called Secondary Markets. In the case of A-paper loans, it's to FannieMae and FreddieMac. There is a similar market for sub-prime loans too, but it is not as competitive. Look at it this way. In the A-paper market, the "retail" lenders like banks set their prices based upon Fannie Mae and FreddieMac's price. The margins are skinny.

In the sub-prime market the retail lenders are more likely to set the actual price based upon what the customer will pay. And that's high enough so that the Secondary market will buy those loans with a substantial profit to the originator. Overall profit has been estimated by some experts as three times the profitability of A-paper loans.

What is more insidious is that if you, an A-paper borrower, go to one of these lenders, they will not tell you, "Gosh, with your credit score, you could get a lot better loan than the ones we offer. Why not go to your bank?" Once you are almost in their clutches they aren't going to tell you that!

What they do is find a blemish your credit report, even a really minor one, and make it sound a lot worse than it is. They tell you that you need credit rehabilitation, but in the meantime they CAN give you a loan at the higher rates. If you are foolish enough to believe that, they got you.

Obviously, according to the study, twenty percent of sub-prime borrowers DO have that choice but aren't aware of it. Then there is the cost. Not only are these loans expensive to get, and expensive to pay during the term, but you have to pay the cost of another refinance to get out of them, a triple-whammy.

Bottom line, as a borrower, regardless of your credit, start out by dealing with an A-paper lender, like your bank, credit union, or an ethical mortgage broker. The Tooth Fairy doesn’t work there either, but you will be more likely to find someone whose primary objective is to get you as good a loan as you qualify for, and who will take you to a sub-prime lender only after all better alternatives have been exhausted.

Be careful out there!